What To Expect When You're Expecting... Default

As markets twiddle their thumbs waiting on Washington to come up with a political solution to the Federal Debt Limit/budget debate, ConvergEx's Nick Colas decided it would be a good time to review the academic literature on how markets discount expectations in the first place. The thinking on this topic has evolved substantially over the years.

The initial thought, first developed in the 1960s, proposed that markets generally "Expected" the outcomes which subsequently occurred. Since then, of course, Colas points out numerous market dislocations have forced a rethink. Behavioral finance posits that human nature skews perceptions of risk and return, causing everything from irrational risk aversion to asset price bubbles. Against this current backdrop of theoretical uncertainty, measures like the VIX are currently somnambulant.

So, using the modern vernacular, WTF? The bottom line, Colas explains, is that Wall Street thinks it has the current "Crisis" all figured out: a last minute deal with no Treasury default. And just as we haven’t sold off materially during this drama, don’t expect a huge (+5%) lift afterwards.

Despite all this over-confidence, investors are backing away from T-Bills en masse as David Tepper is balls to the wall for a disingenuous rise in market multiples taking stocks higher... His proclamation that stocks will revert to their old normal of 18-20x P/E multiples is, however, entirely disingenuous (as @Not_Jim_Cramer points out below)...

Via ConvergEx's Nick Colas,

In light of Eugene Fama winning the Nobel Prize for Economics today, I would like to share my one personal intersection with the great man himself. When I was an MBA student at the University of Chicago, Professor Fama taught a class in Corporation Finance/Capital Markets which was a required part of the curriculum for Ph.D. students and a popular Pass/Fail elective for the rest of us.

At the end of the first class, the following exchange occurred between Dr. Fama and a doctoral student:

Student: Professor, this may be a stupid question, but how do we really know…(Insert highly technical finance question here. I didn’t understand it, but it sounded pretty smart.)

Professor Fama: Your initial assumption was correct. Next question, please.(There were no further questions, and he dismissed class.)

I didn’t take the class, even Pass/Fail. To be fair, Gene Fama had the world by the tail when this brief conversation took place. He had published a wide range of papers supporting the notion that markets were generally efficient and very hard to systematically beat. His work found favor in classroom and the boardrooms of Wall Street. Even now, his work on everything from the agency problem between shareholders and managers to risk and return in capital markets is widely cited in academic literature, to the tune of thousands of citations for scores of his papers.

The intellectual bedrock for Fama’s work that “Markets know best” actually predates him by several decades. In the 1961 John Muth of Carnegie Mellon published “Rational Expectations and the Theory of Price Movements” which proposed that “The economy does not waste information.” Muth’s paper centered on how businesses forecast demand, but the general principle could easily apply to investors in capital markets as well. Markets of all kinds process information efficiently, discounting probabilities and potential outcomes, all without wasting a drop.

As with Mom’s old saying “It’s all fun and games until someone loses an eye,” economists and market observers had to change their tune after the tech stock and housing bubbles in the 1990s and 2000s. That’s where Robert Shiller’s co-win for the Nobel today comes in, for his 1980 paper “Do Stock Prices Move too Much to be Justified by Subsequent Changes in Dividends?” and other work refutes the notion that markets tend to correctly anticipate future economic and fundamental outcomes. His bestselling book, published in 2000, “Irrational Exuberance” isn’t just a nod to Alan Greenspan’s famous observation in 1996; it is also a challenge to Muth’s “Rational” expectations theory from 1961.

As a third axis to the discussion of market rationality/irrational exuberance, you have the work of Daniel Kahneman and Amos Tversky, with their work on “Prospect Theory”. Yep, another Nobel for this one too, back in 2002. Their research essentially showed that humans are lousy at working out what is statistically best for them. One easy example: would you rather have $100 or flip a coin for a payoff of either $250 or nothing, depending on whether you correctly called “Heads” or “tails”? The rational person would choose the coin flip, since the expected value is $125 and therefore greater than the $100 sure thing. In reality, most people choose the $100 because the chance for a loss weighs more heavily on their decision than the potential for greater upside.

In short, how well markets “Expect” – or “discount”, if you prefer – future events is a topic which shifts with time and tide. During strong bull markets, it is natural to think that capital markets are accurately reflecting the intelligence and wisdom of the people who invest in them and the corporate management which generates the business returns which drives stock prices. When you get bubbles such as the dot com craze in the late 1990s or the U.S. residential housing market in the 2000s, another narrative takes hold. The fault is not in our stars, but in ourselves, to quote Shakespeare.

The ongoing threat of a U.S. Treasury default is a useful case study on this point. A few points here:

U.S. stocks are riding a multi-year wave of positive performance and the S&P 500 is finally higher than the two prior peaks in 2000 and 2007. Money flows are starting to return to U.S. equity mutual funds, and exchange traded funds continue to gain assets in products dedicated to domestic stocks.

At the same time, the wounds of 2007-2008 are still fresh in investors’ minds. Remember the lesson of Prospect Theory: losses feel worse than gains feel good.

Capital markets are therefore in a bit of a no-man’s land with respect to whether current prices appropriately reflect the risk of a U.S. Treasury default. The pessimist will say that investors have been lured into a sense of complacency by the strong returns for U.S. equities over the last four years. The optimist will point out that we’ve had a whole slew of rolling crises, from the 2007-2008 market meltdowns to several iterations of European banking system worries to the Fukushima nuclear disaster to constant handwringing over the true state of the Chinese economy. Yes, the Federal Reserve has been in our corner, but the negative case for stocks is well understood. And investors have, for the most part, rejected it.

This is no academic discussion. The price action in U.S. stocks has been uniformly good throughout the partial shutdown of the U.S. government and the threats of a default on U.S. sovereign debt later this week. The CBOE VIX Index sits comfortably below 20, its long run average. What expectations are built into asset prices is a critical question.

The bottom line is clear: U.S. stocks believe there is a zero percent chance of a Treasury default. Not 1%, not even 0.1%. No chance. You can get to this conclusion any number of ways, using any decade’s predominant market narrative.

Rational Expectations/Efficient Markets (Muth/Fama): if there were even a 1% chance of a Treasury default, the VIX would be over 20 and stocks would be retreating, not advancing. Too much of the world’s financial system is predicated on Treasuries as 100% reliable collateral to believe anything else. Russian roulette with a 100 chamber revolver is still too dangerous a game.

Prospect theory (Kahneman/Tversky): Event the remote chance of a loss due to a default would have outsized effects on risk assets like stocks, not just in the U.S. but around the world. Remember that humans fear loss more than they celebrate the chance of an equivalent gain.

Robert Shiller’s long run P/E ratio for U.S. equities does show that stocks are overvalued (see here: http://www.multpl.com/shiller-pe/). You would think that the threat of a U.S. Treasury default would be just the kind of catalyst that could cause a pullback in an overvalued asset class. So far, no pullback, of course.

Two final points here.

First, since stocks currently discount no chance of a Treasury default, don’t look for a 10% pop on news of a deal. A few percent, yes, but not much more.

Second, if Congress and the President cannot come to an agreement by Friday, look out below. Even a one-day “Technical” default simply isn’t reflected in stocks. Under those circumstances, a 10% decline over a day or two would be a logical expectation, regardless of which decade’s philosophy you follow.

For the eating of my asshole if I'm proven wrong on the debt ceiling. In the right bar at the right time with the right waitress, you too would consider warm Gin asshole shots. Especially 2 for 1. Besides, I've already lost my ass shorting this market so it's more of a snack than a meal.

They will pass some mangled bill that raises the debt ceiling & brings back the full force & inefficiency of the beast that is BigGov.Org in all its vast wastefulness & graft & union ass-kissing & banking/WallStreet goodies & MIC pork, probably just before midnight tomorrow.

Bank on it; the wankin' banksters are.

p.s. - Gotta' love how CNN, MSNBC, etc., are literally acting like it will be TEOTWAWKI if Obama doesn't get a blank check within 24 hours. A great, objective media we have in the USSA - NOT!

Would they actually default if they waited until Monday or Tuesday to come up with some deal, or would there just be some carnage in the markets? If it's just carnage, I wouldn't be one bit surprised if they wait until Friday or even sometime next week. Political points must be scored!

The lame Stream Media keeps repetitively stating that Thursday equals default day, and this is a complete lie.

Thursday is the day that the federal government has to look to the Treasury Department for cash on hand to fund operations and debt service, as it will no longer be able to borrow any amounts that would be necessitated by the fact that it continues to spend more than it takes in during any minute, hour, day, month, year or decade(s), like the out-of-control spendthrift that it has been for 43 years.

Without lifting the debt ceiling, and by cutting expenditures, and prioritizing payments due creditors, there's probably a 10 day to 14 day buffer period still before there's any actual default.

SCARE TACTICS IN FULL SWING BY THE STATE CONTROLLED SOCK PUPPET MAIN STREAM MEDIA. TEOTWAWKI ON THURSDAY!!!

We heard that our best and brightest designed a computer model which pays all the bills or none of the bills at all because of the way it was made, it was made that way to discourage political defaults because we know better, we have the money and smart people. End of discussion, cover my ears and bang my forhead against the wall if you disagree, it works every time and besides, I always win.

Let them pass all they want and let the sheep bleat that the tea party are terrorists and are holding us all hostage. It's extra time for you to prep and make plans and plans for those plans and plans for when the plans don't work out because soon enough we will be right back in this situation and the shit really will hit the fan. The math don't lie and the light at the end of the tunnel is another train barreling down on us.

That's entirely possible, but I also threw down the gauntlet a few days ago that I would eat my own asshole if the debt ceiling were meaningfully breached. A Gin soaked ass would help if I lose that bet.

Finally, a use for gin. The only times I ever drank it was when rebuilding carburetors (it doubles as cleaner). The last time I encountered a carburetor was on a friend's houseboat in the mid-nineties.

You have to have large ones to play there. But I'm not at all distressed. Check out hhe 3 year SPY chart and failure to correct meaningfully and then the last times we've gone stupid like that...a la 1987....

Mix in some MZZ and QID and you have a breakfast of champions...predict Monday will be a major stock market capituation, assuming there are no weak hands in the Congress, and they let the cards fall, and Paper Tiger stocks gets shredded.

Fuck ETFs, ETNs, 2X, 3X, etc. Note the volume trading there. Those exits are covered. To hell with swinging for the fences on index moves. Your trade will be tagged, targeted, and sheared before you can whip out your straightedge.

I actually applied the Fuckyo medical plan twice this year. An asshole dentist sent me a $150 bill for what was supposed to be a free consultation. He got the Fuckyo medical payment plan. ie Not a dime from me.

A doctor fucked up my insurance payment and billed the wrong insurance company and tried to stick me with a $500 bill. Not my fault his office is run by idiots. He got the Fuckyo medical plan too. I got a letter saying I'd be sent to collection. I called and said, "I don't care and I'm not paying for your mistake."

The Fuckyo medical plan is genious. About time doctors get paid what their worth. Maybe an assistant anesthesiologist won't be able to make $250k anymore.

I got junked for that? But seriously, they are fun. Debt collectors are easy to fuck with, and most of them deserve it. I haven't had a call from one for a couple of years, and I miss them (not really, becuase that means I'm about to step into a shitfest, unless they're looking for somebody who doesn't live with me, then it's good times.) I can tell them that I'm on WebRecon and they shit a brick.

you're probably right but let me enjoy the fantasy that the hard corp conservatives in congress have been conspiring with the Military to stage a coup over the criminals that are destroying our country...and that by design there will be no deal.

"...The title is a phrase spoken by Winston Smith to Julia in George Orwell's novel 1984, the basis for the second half of Bowie's album. This is Bowie's interpretation of the couple's capture, and Winston's thoughts about the whole affair. He recognizes that they probably should have ended it while they could, before it was too late. However it is too late, as the song says, "...because of all we've seen, because of all we've said, we are the dead..."

Neflix $900 a share. Not like the price means anything anymore. Fuck, make the new benchmark $10k a share. Priceline can maybe make it there next year.

Analysts can try to claim that the market is priced correctly, or future growth justifies current p/e ratios, but they're wrong.

The growth doesn't exist and claimed revenue is about as realistic as the DDD tits on a Vegas stripper.

You can claim unicorns exist all you want, but I'll still tell you they don't.

In fact if I got on TV and told people unicorns exist, I'd be laughed off the stage. Yet if I got on TV and claimed Tesla is underpriced and worth $275 a share. I'd receive nods and most likely be applauded. Honestly, I'd believe the guy claiming unicorns are real over a guy claiming Tesla is worth $275 a share.

I got a smaller violin for you use, that big one you have is about to weigh you down and perhaps bury you under it, i'll rent it to you for 5 cents a day, but you got talk to dr. lucy for an hour and keep her happy once a month. Suicide class is tonight and it's packed with all sorts of weirdo's if that suits you better.

Cut him some slack, he has established a case that the Nobel prize for econ is completely fraudulent. The proponents of the Prospect Theory are either unaware of, or ignoring the St. Petersburg paradox.

Human decisions are not a mathematical process and doobey any mathematical equations. Value is not quantifiable. These are facts. Behavioural economics is pseudoscience, much like the rest of the subject.

Hmm, 80 on the DXY. The whole world still wants USDs for funding their crony sh*hole economics and providing backstops for their insolvent crappy banks. Lanagade is paranoid that the IMF funding will diminish. We could be at the cusp of a USD crisis.

Power is fleeting and the emperor is a naked a-hole.

Popcorn...

"The day is not far off when the economic problem will take the back seat where it belongs, and the arena of the heart and the head will be occupied or reoccupied, by our real problems — the problems of life and of human relations, of creation and behaviour and religion" Keynes. lol...well done commies! You f*cked it up.

The nation will not default on its debts because it violates the Constitution unless… the “I-will-not-negotiate” despot in the Oval Office, in another power grab, trashes the Constitution again, and defaults anyway.

Right Scoopon October 7th, 2013, reports that Coburn dispelled the default myth…

“Senator Tom Coburn was on with CBS This Morning today and took a moment to dispel a rumor that he says ‘you hear on every newscast’ that if we don’t raise the debt ceiling we will default. He says that’s not true, that we will go on paying our interest on the debt we’ve accumulated and that we’ll redeem current bonds and issue new bonds.”

Says RS: Here’s a video that was created a couple of years ago by Bankrupting America to help people understand the debt ceiling and it backs up what Coburn is saying.

“Basically the media has just been parroting what Obama and his yes men have been saying over the last few weeks, that if we don’t raise the debt ceiling the country will default, without even fact-checking it. And this is setting up what Mark Levin has been predicting for several weeks, that Obama will uses this ‘crisis’ to raise the debt ceiling without Congress. And the media will have carried him on their shoulders to help him do it, despite the fact that it violates the Constitution."

Says Senator Mike Lee: “A default would happen if we stopped paying the interest or principal on our national debt, and the 14th Amendment prohibits that from happening. So one way or another, default is not going to occur."

THANK YOU. What does it mean to default on our debt? Not paying the interest. Change of this: 0. Why? Even after the debt ceiling is hit, the U.S. will see have tax powers - which debts/obligations will they be sure to pay? Interest on our debt? You bet. What would they not pay? Well, food stamps, gov't worker salaries, ....

Can't raise the debt limit? Then gov't can only pay out what it takes in from tax receipts. things get cut but it wont be the interest on our debt...

Take a look at this article Dan. The real concern is not the interest itself, but the ability to also pay back the principle at maturity if treasury holders increasing choose to not "roll over" their investment into new treasuries (no new debt created by roll overs). If more and more people decide they want their treasuries to mature based upon the insecurity reguarding US solvency, then more taxpayer money is paid out to matured principles instead of entitlements.

Maybe this is why food stamps may be (temporalily) cut: To make sure the treasury doesn't default on maturing principle.

I'm not sure why you say "don't expect them to soar either." Given the last 4-5 years as a guide I don't see why not. They've got Yellen at the printer. The pattern since S&P 666 is to be at point X with no crisis, crisis happens and it goes down 50-100 points, crisis averted it goes up 100-200 points...and eclipses where we were w/o the crisis in the first place. As long as the market is priced in $ and they keep pumpin more of them we are going up, until we go hyperbolic or there is rampant inflation

"One easy example: would you rather have $100 or flip a coin for a payoff of either $250 or nothing, depending on whether you correctly called “Heads” or “tails”? The rational person would choose the coin flip, since the expected value is $125 and therefore greater than the $100 sure thing. In reality, most people choose the $100 because the chance for a loss weighs more heavily on their decision than the potential for greater upside."

The rational person would also choose the coin flip if the choice is between getting nothing and getting $201. Oh, and he needs the money because his foodstamps have been cut off.

I wonder how market theory works with massive fraud. I am not an economist but I do understand that it is the model that matters and not the primary set of realities the model represents.

Money manager Catherine Austin Fitts says, “You are seeing a tug of war between the new system that’s coming up and the old system that’s struggling and dying.” Fitts explains it by saying, “Let’s pretend we have a company called USA, and we create a new company called Breakaway Civilization.We move all of our assets out of USA and put them in Breakaway Civilization. We leave union obligations and pension funds . . . in the old USA economy.” Fitts warns, “I think bail-ins are coming . . . the big question is not will we be able to get out insured deposits. I think the big question is how violent will things get?” Fitts biggest worry is not financial collapse. Fitts contends, “I don’t think the people who run the U.S. military or run the United States government are going to say we’re happy to collapse rather than go to war. They are going to go to war. They’re going to shake somebody down.” Fitts goes on to add, “I think gold is the greatest form of insurance you can have during this transition period.”http://www.silverdoctors.com/catherine-austin-fitts-big-question-is-not-...

Once the debt ceiling/shutdown mess is cleared up, capital will flow back into u.s. equities in a big way. zh has been talking the market down for what? 6 years now? The equity bull market hasn't started yet.

Safe havens are disappearing and big money will have nowhere else to go.

I used to be a contrarian myself. But I realised that it was constantly losing me money in the markets. Now I'm just a realist. There will be no crash for a few years minimum.

Gold is still in a bear market and is about to head for 1200, then 1000. It will bottom and head for maybe 2500 but not a lot more. Gold is not workable as a monetary system.

Please call your local Chinese/Russian/Indian consulate and voice your opinion. Better still, you are more advanced in your monetary understanding than the founding fathers, please call your local congresspig and ask the Constitution which established sound money as law be modified to fit your view as well

I think this guy misses the point, the reason the markets have not really been affected has nothing to do with how stocks will be affected by a shutdown, it has to do with how QE will be affected by a shutdown.

The shutdown is really a separate thing than the QE. Most people have figured that QE cannot stop, at least for a middle range, therefore the stock slowly ratchets up its PE....